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1 INVESTMENT THEMES IN 2015 Dealing with Divergence Citi GPS: Global Perspectives & Solutions January 2015 Citi is one of the world s largest financial institutions, operating in all major established and emerging markets. Across these world markets, our employees conduct an ongoing multi-disciplinary global conversation accessing information, analyzing data, developing insights, and formulating advice for our clients. As our premier thought-leadership product, Citi GPS is designed to help our clients navigate the global economy s most demanding challenges, identify future themes and trends, and help our clients profit in a fast-changing and interconnected world. Citi GPS accesses the best elements of our global conversation and harvests the thought leadership of a wide range of senior professionals across our firm. This is not a research report and does not constitute advice on investments or a solicitation to buy or sell any financial instrument. For more information on Citi GPS, please visit our website at

2 Citi GPS: Global Perspectives & Solutions January 2015 Amitabh Arora Head of G10 Rates & Securitized Products Research Robert Buckland Chief Global Equity Strategist Naoki Iizuka Japanese Economist Eric G Lee Commodity Strategist Andrew Pitt Global Head of Citi Research Ebrahim Rahbari European Economist Willem Buiter Global Chief Economist Peter D Antonio US Economist Shuang Ding Senior China Economist William Lee Head of North America Economics Tobias Levkovich Chief US Equity Strategist Hans Lorenzen Head of European IG Credit Products Strategy Team Tsubasa Sasaki Japanese Technology Thematic Research Michael Saunders Head of Western European Economic Research Sofia Savvantidou Head of European Utilities Research Richard Edwards Head of Global Consumer Discretionary Research Roger Elliot European Transport Analyst David Lubin Head of Emerging Markets Economics Guillaume Menuet European Economist Mark Schofield Global Head of Macro & Strategy Product Minggao Shen Head of China Research Tina M Fordham Chief Global Political Analyst roger.elliott.com Ian Goldin Director of the Oxford Martin School at the University of Oxford Jeremy Hale Head of Global Macro Strategy Edward L Morse Head of Global Commodity Research Richard Morse Commodities Strategist Kiichi Murashima Japanese Economist Jason Shoup Head of US High Grade Credit Products Strategy Team Malcolm D Spittler US Economics Analyst Anthony Yuen Global Energy Strategist Keith Horowitz, CFA US Banks & Broker Analyst Dana M Peterson North American Economist

3 January 2015 Citi GPS: Global Perspectives & Solutions 3 Andrew Pitt Global Head of Research INVESTMENT THEMES IN 2015 Dealing with Divergence We are pleased to present our investment themes for 2015 and we wish all readers of our Citi GPS series successful investing in the year ahead. As in 2014, these themes are a mixture of macro and asset class views together with several ideas selected from our global industry analysis. At the end of each year we conduct a survey to ask users of Citi Research which themes they would like to see us tackle in the year ahead 1. We have used the intelligence of this survey to scope this annual Citi GPS Investment Themes report. Economic divergences are likely to create material variances in monetary policy in 2015 and beyond. Overall our economists expect a slight pickup in global growth to around 3.1% in 2015, up from 2.7% in 2014, but also expect the growth gap between developed and emerging economies to be at its lowest level since the start of the millennium. Key downside risks in the year ahead center, in our view, on China s domestic economy, continued underperformance in the euro area, potential geopolitical shocks and the weakening support for global economic integration. Key upside risks would most likely center on the boost to consumers from lower commodity prices and the impacts of loose monetary policies, especially in advanced economies. Across 2014 our asset allocation framework recommended an overweight position in equities but, while equities outperformed other asset classes, the margin was not as comfortable as expected, especially relative to government bonds. In the year ahead, our strategists still view equities as the asset class outperformer 2, buoyed by solid corporate earnings growth (we forecast 9% globally), highly accommodative monetary policy in advanced economies and valuations which look supportive by historic standards. After the stronger than expected performance in 2014, we forecast core government bond returns to be weak with higher yields forecast across the board. The expected back-up in benchmark rates creates a headwind for credit total returns, although expected QE from the ECB should support European credit over the US. In early December we were forecasting positive returns on major commodities through to end-2015 but below historical average returns. The continued precipitous fall in the oil price in the past year 6 weeks has taken the price well below what we see as an equilibrium level but the structural backdrop within the energy industry suggests that pressure may remain near term. To provide context to our asset class predictions, we examine in detail in the first section of this report the issue of central bank policy and then follow this with analysis on inflation, energy prices and the position of China in the global economy. All four of these topics were of central concern to investors in our theme survey. We then examine the outlook for the globalization of trade and financial flows as well as the risk of exogenous shocks in a world where geopolitical risks have arguably risen to levels not seen since the fall of the Berlin Wall in Several of our leading Equity analysts review three themes at the end of this report that have direct downstream implications for equity securities. These themes are e- commerce, where we examine the growth of the online retail sector, especially in emerging markets; battery storage, where we assess the market opportunity and also what this opportunity means for technology companies, utilities and commodities; and the impact of Fed policy on US banks. 1 See Investment Theme Survey Results, Citi Research, 19 December See Asset Allocation: Citi House Views for 2015, Citi Research, 1 December 2014 and Global Equity Road Ahead 2015, Citi Research, 6 January 2015.

6 6 Citi GPS: Global Perspectives & Solutions January 2015 Mark Schofield Head of Global Strategy & Macro Product Central Banks: A Year in Transition Citi forecasts see the US Federal Reserve (Fed) and the England s Monetary Policy Committee (MPC) tightening from the end of 2015, which we feel is consistent with the state-contingent policy objectives of the central banks. Clearly, however, the continually shifting sands of the macroeconomic and political backdrop make the current state anything but steady and so there are clear risks to the timing which, at the time of writing, appear to be skewed to a slightly earlier mid-2015 lift-off. Ultimately, however, rates will rise and we believe that the magnitude and pace of the eventual tightening is likely to be more important for markets than the exact date of the first move. Certainly, however, the consensus appears to be for earlier moves than Citi forecasts and, with that in mind, markets will soon begin assessing what a US (and UK) tightening cycle will mean for asset prices. In the meantime, however, the European Central Bank (ECB) and the Bank of Japan (BOJ) look likely to continue easing. With this they will maintain an accommodative global policy stance and assume the mantle of liquidity provider from the Fed. Over the course of the next couple of years, however, the dominant theme in global policy is likely to remain that of divergence. When and How Fast Will the Fed Hike Rates? William Lee Head of North American Economics In the December 2014 Federal Open Market Committee (FOMC) meeting, Chair Janet Yellen was explicit about the preconditions for the liftoff of interest rates with participants expecting some further decline in the unemployment rate and additional improvement in labor market conditions and core inflation to be running near current levels but foresee being reasonably confident in their expectation that inflation will move back toward our 2% longer run inflation objective over time. This implies the best time for liftoff would be where the economy is expanding at its maximum above-potential pace. In the face of the surprisingly sharp decline in the price of oil, GDP growth is expected to get a substantial boost in With the oversupply of oil expected to persist for some time, there may be a prolonged, albeit temporary, boost to GDP growth in the first half of This additional growth spurt would be sufficient to reduce the output gaps and absorb labor market slack more rapidly than forecasted even a month ago. Consequently, the best time for liftoff would be the second half of 2015 when lower oil prices would have provided the additional lift to GDP growth to ensure that the Committee would be most confident in its forecasts for rising inflation towards but not above the 2 percent target. Consistent with this, our December 2015 liftoff call is predicated on the Committee delaying liftoff until there was sufficient information about the recovery to ensure its sustainability. However, Chair Yellen raised an important consideration that raises the chances of an earlier move: The Committee would want to place the initial increase at the point of maximum growth where GDP growth is well above potential and the output gap is diminishing rapidly such that inflation expectations and projected inflation would likely be rising, and financial markets would be least disrupted with a rate increase at that time. We believe the trajectory for policy rates is by far much more important than the liftoff date for influencing long-term interest rates, economic growth and inflation. Regardless of the liftoff date mid-2015 or end-2015 we continue to project the trajectory toward normalization will rise slowly, approximately 75 basis points a year. We project a slow start (even slower if we have a mid-2015 liftoff), towards an eventual target of about 3.75%. Our policy path forecast is slower than the trajectory implied by the FOMC.

8 8 Citi GPS: Global Perspectives & Solutions January 2015 A key obstacle to QE is likely to be Germany. Although the Bundesbank is not alone in expressing concerns about large-scale purchases of government bonds, we nevertheless believe that this opposition is not unconditional and will probably be lessened over time by continued inflation undershoots and the preference by some of the budgetary hawks for monetary stimulus over fiscal easing. Following President Draghi s Frankfurt speech on November 21, 2014, we remain convinced that ECB QE is only a matter of time and the Governing Council is likely to make a formal announcement at the January 22 meeting. However, a successful implementation of the private sector asset purchase program could enable the Governing Council to wait until March 5. A key uncertainty remains whether the Governing Council will be successful with its first QE attempt whereas it took a number of iterations for many central banks to deliver the appropriate stimulus their economies required. Our QE baseline contains 600 billion of private sector asset purchases to reach the intended 1 trillion target, alongside a generous 500 billion of targeted longer-term refinancing operations (TLTROs). Despite these assumptions, our central projection does not envisage headline inflation reaching the ECB s target over the forecast horizon. As a result, we argue that further rounds of QE could very well be on the ECB s mind at some stage during the second half of Japan Remains Committed to 2% Inflation Target Kiichi Murashima Japanese Economics Naoki Iizuka Japanese Economics The Bank of Japan s (BOJ) surprise decision in October to ease monetary policy further indicates policymakers are more strongly committed to the 2% inflation target than the average market participant had assumed. However, unanswered fundamental questions remain on whether and how further increases in the monetary base and the BoJ s holdings of Japanese government bonds (JBGs) and risk assets can cause a sustainable convergence of Japan s inflation to 2% apart from their direct impact on the currency rate. In explaining the surprise easing, the BoJ noted that policymakers dealt with the rising risk that the oil-driven drop in inflation will push inflation expectations lower again. However, given that the BoJ s core inflation forecast of +1.7% YoY for fiscal 2015 is predicated on higher oil prices, the BoJ will probably need to ease further in 2015 if, as we anticipate, oil prices remain flattish into Figure 3. Citi estimate of energy s contribution to YoY changes in the core CPI (ppt) Petroleum product Electricity City gas Total Note: Energy includes petroleum products, electricity and city gas charges Source: Ministry of Internal Affairs and Communication, Citi Research Figure 4. Citi s estimate of core CPI inflation (YoY) Actual Forecast Source: Ministry of Internal Affairs and Communication, Citi Research

9 January 2015 Citi GPS: Global Perspectives & Solutions 9 Jeremy Hale Head of Global Macro Strategy Mark Schofield Head of Global Strategy & Macro Product Tobias M Levkovich Chief US Equity Strategist We currently expect additional BoJ easing in July 2015 in the form of increased purchases of risk assets and possibly JGBs. Assuming that the BoJ maintains the current pace of asset purchases in years to come, the BoJ s holding of JGBs will reach 280 trillion at end-2015 (57% of GDP) and 350 trillion at end-2017 (71% of GDP), which is unprecedented territory. We are skeptical that the 2% inflation target will be met in the foreseeable future on a sustained basis. And, at some point, the difficulties in making further large-scale JGB purchases from Japanese banks (who may need a certain amount of JGBs as collateral for transactions), plus a sense of fatalism about the extent to which QE can help achieve the 2% inflation target, might prompt the BoJ to taper bond purchases. But that time is probably distant at present, and in any case, the BoJ would still have options to buy other assets (e.g. ETFs). Can ECB and BOJ QE replace Fed QE? There is much speculation as to whether or not a dollar equivalent of ECB or BOJ QE will have the same impact as a dollar of Fed QE. Overall, the global balance sheet will continue to expand in 2015 and that, all other things being equal, should continue to be supportive for risk assets. The question is; to what extent? The expected size of 2015 QE does not give us much to work with. As our Global Macro Strategy team has pointed out, a consolidated G4 Central Bank balance sheet in US dollar terms has risen 9.5% annualized since early Using Citi FX forecasts, and assuming the ECB takes two years to raise the balance sheet by 1 trillion, the consolidated US dollar balance sheet will still rise by a 6-7% annualized average over 2015 and This seems to imply slightly less support externally from QE than before. However, an alternative specification of the balance sheet GDP weights the change in the individual balance sheets and finds that local currency based balance sheet expansion will be around 21-27% in 2015 and 2016 vs. 19% annualized since early This view of reality says central bank largesse is getting bigger not smaller. The more salient issue may be the transmission mechanism to global markets and on that front there is a clear risk that 2015 QE does not match previous years. While the US represents about 22% of world GDP against almost 30% for the ECB and Japan, the US equity market represents 40% of the global equity market capitalization against about 20% for the Euro zone and Japan combined. This suggests that while ECB and BOJ QE may have a meaningful impact on local assets, the effect on global markets may be more muted. When we consider too, that ECB and BOJ QE may soon be taking place against a backdrop of tightening US monetary policy, it is less obvious that QE will remain a major prop for financial assets through 2015 and into Hope May Meet Change It has become more evident to us that investors have relatively short memories, possibly reflecting the experience base of so many investors overlaid with what psychologists call recency bias. Keep in mind that we suspect that about 65-70% of Wall Street professionals probably have ten years or less of investment experience with maybe another 20-25% having 20 years under their belts leaving relatively few with a good memory of the secular bull markets of the 1980s and 1990s. In this context, not many within the investment community can even recall an era of inflation, the Plaza and Louvre accords on currency, energy shocks, LTCM and a host of other market/ economic events. In this sense, investors perspectives on stocks are skewed by recent trends and patterns such that there is little understanding of what happens with the Fed lifts rates.

10 10 Citi GPS: Global Perspectives & Solutions January 2015 Figure 5 provides some insight and shows that equities generally climb for many more months after the first Fed move. There are clearly exceptions including the 1969 GM strike that hampered the economy, the Arab-Israeli war of October 1973, the October 1987 crash, the tech bubble bursting in 2000 and the financial crisis of And there is not that much consistency on what specific industry groups one should buy after the first interest rate hike. An investment community that has not seen trends in interest rate policy headed higher for years adds to uncertainty, especially as so many have limited experience and still think that the global economy is typically synchronous when history suggests otherwise. We believe that the 2014 gains are behind us but we remain buyers on weakness for 2015 upside with a continued preference for large caps and value. Figure 5. S&P 500 performance following first rate increase Performance After 1st Rate Increase Date of Hike Date of Peak % Change # Days to Peak Date of Trough % Change # Days to Trough 4/15/1955 8/2/ % 328 5/17/ % 22 9/12/ /12/ % 817 N/A 7/17/1963 9/25/ % 1,056 7/22/ % 3 11/20/ /29/ % 235 3/5/ % 71 12/18/1968 N/A 5/26/ % 358 7/16/1971 1/11/ % /23/ % 91 1/15/1973 1/18/ % 3 10/3/ % 434 8/31/1977 9/22/ % 773 3/6/ % 128 9/26/ /10/ % 767 8/12/ % 473 4/9/1984 8/25/ % 854 7/24/ % 73 9/4/1987 2/2/ % 1,622 12/4/ % 63 2/4/1994 2/18/ % 766 4/4/ % 39 3/25/1997 6/30/ % 571 4/11/ % 12 6/30/1999 3/24/ % /9/ % 823 6/30/ /11/ % 2,611 3/9/ % 1,180 Average 50.23% % 269 Median 39.11% % 82 Note: April 1955-April 1984 rate hikes are based on increases in the discount rate: Sept-97-current dates are based on increases in Fed Funds rate. Source: Federal Reserve, Haver Analytics, Citi Research What Does Fed Tightening Mean for US Treasuries? Amitabh Arora Head of G10 Rates & Securitized Product Research Fed tightening has historically resulted in a flattening of the yield curve and we expect a similar reaction in this cycle as well. There are some differences between the upcoming hiking cycle and past monetary tightening cycles. For one, the Fed is starting lift off from the unusually low zero bound, and the end point for this cycle is likely to be lower than in the past, potentially as low as 2 to 2.5%, given the benign inflation picture facing the Fed. Therefore, it is possible that the 5-year and 10-year rates at the end of the Fed s hiking cycle could be below 3%. Further, the Fed holds a large balance sheet as a result of its asset purchase programs, and the existing reinvestment program would continue for a brief period even after the lift off in rates. Thus, the impact of tightening on long term yields is likely to be muted. The pace of tightening may not be measured, as in past cycles. Therefore the front end of the curve could see some volatility as the market fine tunes expectations of the pace of hikes right up to, and beyond the point when the Fed starts liftoff. What about the Treasury-Bund Spread? Bunds have rallied relentlessly over the past 12 months, reflecting a deterioration of inflation expectations and the associated need for additional non-conventional monetary stimulus. As a result, the 10-year Treasury-Bund spread has widened by 55 basis points in 2014, confirming calls for a gradual de-coupling of these two

11 January 2015 Citi GPS: Global Perspectives & Solutions 11 Jason Shoup Head of US High Grade Credit Products Strategy Team markets. Currently, there is a very high probability of the ECB announcing QE at its January meeting. We expect the Treasury-Bund spread to widen only in the case of a disappointing announcement, one which does not address the issue of excessive real interest rates in the euro area. In our baseline scenario, we project Bund yields to grind higher during the course of 2015 albeit at a very modest pace (1.15% at year-end). Our leitmotiv is best described as buy the rumor, sell the fact, when it comes to ECB QE. In terms of the Treasury-Bund spread, our projections do not imply a clear direction and we should end the year close to current levels. This contrasts to the 15 basis point widening priced in by the respective forward curves. Credit: All Good Things Come to an End While global monetary conditions should remain bond market-friendly in the year ahead, the end of Fed QE leaves the market in a precarious position. If 2014 is anything to go by, the technical environment that was priced just right for creating endless demand and suppressing volatility has passed. Investment grade (IG) spreads are unlikely to return to their mid-2014 tights anytime soon and 2015 should provide further confirmation that the credit cycle has turned albeit with a longer denouement than has been historically typical. Apocalyptic talk aside, the US IG credit market enters 2015 in a position where the risks are far more symmetric relative to Thus, we begin the year with a neutral view of the asset class. Said differently, it is likely that the move wider in spreads experienced in the latter third of 2014 already appropriately reflects the deterioration in technical conditions. Still, the end of credit s Goldilocks-era is likely to be felt in other ways. We expect more single-name volatility, issuance to remain heavy enough to warrant meaningful concessions, and an even greater emphasis on fundamental risk as the energy sector, M&A, and shareholders take center stage. Hanz Lorenzen Head of European IG Credit Products Strategy Team While spreads are likely to travel along a bumpier path in 2015, we expect the IG corporate cash index to end the year roughly unchanged, plus or minus 5 basis points. If that is the case, excess returns should fall somewhere in the basis point range, absent a dramatic reshaping of the curve. In Europe, our credit strategists are forecasting a 20-25% tightening of Euro credit spreads which is at the bullish extreme of expectations for Their premise is that the single biggest problem that credit faces is low returns. Ever more extreme scenarios are needed to generate just half decent performance. In 2015, Euro IG credit can only return 4% if the yield on the index drops below 1% (from 1.4% currently). Specifically, our concern is that the ECB might end up squeezing corporate credit much more than consensus or even our forecasts imply, for instance by buying corporate bonds outright in size. This isn t that farfetched an idea. From the day the ECB announced its asset-back security (ABS) and covered bond purchase program to the time when it got around to actually spending the first euro, spreads in both markets nearly halved. We understand that the ECB has been heavily involved in covered bond primary markets, buying 50% or more of some new deals, suggesting that it is prepared to crowd out private investors in size. Where would we be if the same thing happened in Euro IG corporate credit? Well, that is exactly what would take the index yield sub-1% with a repressed level of volatility. Great for instantaneous performance, but return prospects from there would be almost non-existent, beyond a smidgeon of carry. Until the ECB backed off, there would be little scope for a cathartic correction. It could happen all too quickly: if the ECB launches full-scale QE in January, then credit just might be there already by the end of the first quarter.

12 12 Citi GPS: Global Perspectives & Solutions January 2015 How Far can Policy Divergence Move FX Markets? Jeremy Hale Head of Global Macro Strategy Volatility in FX markets has increased (Figure 6) with policy divergence remaining a key theme in FX markets. Both Japan and the euro area are using aggressive monetary ease to try to ward off deflationary risks, with currency depreciation effectively the intermediate target. Compared with the Fed, for example, ECB QE cannot possibly have as large an effect through overall financial conditions given that credit spreads and yield levels are much lower, and equity valuations much higher, than when the Fed started QE. As this has become clearer to markets, US dollar gains have continued (Figure 7). US dollar cycles tend to be quite long lasting once started, with rallies typically running for 5-6 years. This would imply that the current rally, which began in 2011, could run through to the end of Thus far, the gain in the G10 US dollar indices is around 17% from the lows compared with a typical 40% rally historically. In the real broad indices, which include emerging markets (EM), the gain is still less than 10% with 30% marking the typical historical move. As a result, we see further US dollar upside over the medium to long term with US dollar gains vs. G10 currencies of the order of 10% over 12 months and 20% over two years. We still forecast less than this in the EM space where we expect US dollar gains of about 4% over the next 12 months. But it seems increasingly clear that key EM policymakers are less than happy with the combination of weak growth at home and FX depreciation in Japan and the euro area. China, for example, cut rates in November 2014 and other Asian country policymakers could also ease policy or step up intervention to offset European and Japanese policy impacting local inflation too much. Risks to the EM forecasts are likely to the weaker side. Figure 6. Implied volatility: G10FX (blue) vs. EM FX (red) Figure 7. USD vs. LatAm (red), CEEMEA (green), World (grey dash, G10 (blue), Asia (black) Source: Bloomberg, Citi Research Source: Bloomberg, Citi Research Are Emerging Markets at Risk from Fed Tightening? David Lubin Head of Emerging Market Economics The experience of the past 40 years suggests that capital flows to EM can go into reverse during periods of US monetary tightening, but there are three factors which should limit this fear in The first is that there has been an important change in the composition of capital flows in the last couple of decades: commercial banks are no longer the dominant supplier of cross-border flows to EM; institutional investors are. This is important because commercial banks are the creditors most likely to have the highest degree of sensitivity to an increase in the front-end of the US curve. The second is the evidence that home bias among institutional investors has

13 January 2015 Citi GPS: Global Perspectives & Solutions 13 declined rather sharply. On a scale of 1 to 0, where 1 represents complete home bias and 0 its complete absence, the advanced economy members of the G20 have seen their home bias fall sharply in recent years: from 0.76 in 1995 to 0.58 in This is likely to be a structural change. Finally, the expected US monetary tightening in 2015 will take place against a background of monetary policy divergence in the advanced economies: the fact that rates in Japan and the Eurozone should stay very low will help to mitigate the impact of rising US rates. Figure 8. Commodity exporters with current account deficits seem likely to remain among the most vulnerable countries within EM Current Account Surplus Current Account Deficit Commodity Exporting Russia Nigeria Venezuela South Africa Brazil Indonesia Peru Manufactures Exporting Korea Hungary Poland Israel India Turkey Figure 9. but there are reasons to be optimistic about capital flows to EM, possibly due to a sustained decline in global home bias $ bn Quarterly capital flows to 30 emerging 100 economies Q1 2006Q4 2008Q3 2010Q2 2012Q1 2013Q4 Inward Portfolio Equity Inward Portfolio Debt Source: Citi Research Source: Institute of International Finance, Citi Research But there is one country in which cross-border commercial bank lending has been very aggressive, and where capital outflows seem likely: China. Data from the Bank for International Settlements (BIS) on cross-border bank lending to EM show that international lending to China has risen very dramatically in the past few years. Since the first round of QE, China s international debt to banks has risen by almost $900 billion, creating a stock of external bank debt of over $1 trillion (more than half of this rise took place in the past 2 years) some 10% of GDP. Of this stock, 80% has original maturities of less than one year. It is sensible to argue that the vast bulk of this largely short-term debt has been accumulated in the context of speculative capital inflows: China s currency has been a one-way-bet since 2010, and dollar funding costs have been exceptionally low. Now these two factors are in transition: the Chinese currency has been exhibiting more two-way risk in recent months and, as US rates rise, there is a much greater chance that China suffers speculative outflows rather than speculative inflows as has been the case in the past few months - particularly as Chinese rates fall next year. Of course, a large speculative outflow from China can easily be financed by the central bank. But a large capital outflow could, we think, increase some of the downside risks to Chinese growth, and could also set the stage for a more depreciated renminbi (which is in Citi s forecasts).

14 14 Citi GPS: Global Perspectives & Solutions January 2015 Conclusion: Testing Times Ahead Overall, we think that central bank policy will continue to be supportive for financial assets in 2015, with equity markets likely to be the best performing. However, we would be wary of becoming complacent about the ability of QE alone to keep driving markets higher. The early part of the year will likely be a period of further policy accommodation as QE shifts east from the US and UK to Europe and Japan. We expect this to continue to suppress volatility and support the ongoing reach for yields; however we suspect that the impact of 2015 QE may be more noticeable at the local market and local asset level than at the global level. As the US cycle starts to turn we think the risk of higher funding rates and some more exaggerated moves in currency markets could start to undermine confidence, boost volatility and raise risk premia. As the Fed and the MPC begin to raise rates, equity markets are likely to focus on rising growth and better earnings. However the impact of higher funding rates and eventually rising bond yields cannot be ignored. Significant moves in currency markets (with the US dollar in particular expected to rise) will continue to act as a dampener on headline growth and to globalize low-inflation. So long as inflation remains subdued and policy rates are normalized slowly, the damage to risk appetite from higher rates is likely to be fairly limited. A meaningful shift back to fixed income from equity is highly unlikely while the yield gap is so low (or inverted) and while economic growth remains positive. Equally, bond markets may not need to sell-off much at all, at least not until some of the fundamental drivers of yields (funding rates, inflation risk or default risk) begin to rise. With slow but steady growth, low inflation and such low interest rates globally, bond and equity markets can probably continue to co-exist for some time. This does not, however, mean that 2015 will see the kind of returns that 2014 delivered. Further upside from current levels in equity markets and such low bond yields will be hard earned. The environment is becoming more conducive to lower absolute returns and with greater risk. With greater divergence geographically, across sectors and among individual names, picking the right asset is likely to be more important in 2015 than picking the right asset class.

15 January 2015 Citi GPS: Global Perspectives & Solutions 15 Mark Schofield Head of Global Macro & Strategy Product Asset Allocation: Diversification, not Rotation The big trends in asset flows going forward are likely to be driven by secular rather than cyclical factors. We see many good arguments for investors to raise equity allocations from their considerable cash holdings but we see little reason for large structural reductions in fixed income allocations at the current time. Diversification, Not Rotation Many commentators are anticipating a great rotation of assets out of bonds and into equities as economic and central bank policy cycles turn. However we believe that new trends in investor behavior, changing patterns in the global economy and a shifting regulatory landscape have probably consigned such cyclical rotations to history Indeed, we question, whether such a dynamic ever existed. Certainly we believe that it is unlikely that we will see the return of cyclical cross-asset allocation moves of this nature any time soon. It is our contention that many of the apparent cyclical cross-asset flows in the past have been co-incidental rather than a result of a direct causative relationship, in which the selling of one asset is the direct trigger for buying of the other. There are cyclical risk allocations continually taking place in every asset class as investors buy and sell based on return expectations relative to a perceived risk-free rate. Due to the highly correlated pre-crisis global economy, the cyclical risk rotations in bonds and in equities have often been nearly simultaneous. Figure 10. Intra-asset cyclical risk rotations Risk Reduction (profit taking) Capital Preservation (cash) Hiking Cycle (bear flattening) Recession (bull steepening) Equities Fixed Income Capital Growth (cyclical) Income Generation (defensive) Growth (bear steepening) End of Easing cycle (bull flattening) Source: Citi Research As paths in economic growth around the world have diverged, global aggregate flows within the various asset classes have become more neutral. On top of this, there are a number of new trends that have emerged in recent years that are causing investors to diversify portfolios beyond the bounds of the traditional fixedincome and equity parameters. These include a changing investor base with growing demand for hedge funds and solution based mandates, the emergence of new asset classes, notably commodities, real estate and foreign exchange funds, and a continually changing regulatory environment.

16 16 Citi GPS: Global Perspectives & Solutions January 2015 Cyclically driven moves in risk allocation are now being played out in within asset classes in increasingly diverse portfolios. Weaker correlations between asset classes have meant that hedging traditional cyclical risks has become a more prevalent strategy than aggressive directional risk taking. Meanwhile lower volatility has meant that regional, stylistic and cross-sector trading strategies within asset classes have become the tools of choice for trading cyclical risk. A secular shift to equities may be underway? The biggest drivers of cross-asset flows going forward are therefore likely to be secular rather than cyclical (we actually believe that this has always been the case). In this space we do see scope for a meaningful reallocation towards equity markets. The biggest reallocation of assets that has taken place in the past decade has been de-risking out of equities and into cash. The trend towards diversification means that this move is unlikely to be reversed in its entirety but low rates and low volatility could be the trigger for some secular re-risking which could generate a significant increase in demand for equities over the next few years. However, in the near term at least, we believe that this will be a reallocation out of cash and not from fixed income. There is now a lot of cash in the system and low rates and low volatility are intensifying the pressure on investors and companies to put that cash to work. Based on current portfolio allocations and risk-adjusted return expectations equities may therefore be the beneficiary of a period of raised secular demand. Flow data certainly suggest that the secular demand for equities may be turning after nearly two decades of contraction and we expect the aggregate demand for equities to continue to rise. Figure 11. Cumulative Flows ($bn) 1,500 1,300 1,100 Equities Cumulative Flows ($bn) 900 Bonds Cumulative Flows ($bn) Source: Citi Research, EPFR

17 January 2015 Citi GPS: Global Perspectives & Solutions 17 We see three potential sources for a significant uptick in demand for equities: First, retail investors and the High Net Worth sector in particular have been extremely cautious since the financial crisis. This sector remains underweight and has not fully participated in the upturn. With the rally in bond markets last year, this has not been disastrous for them, but with 10-year US Treasuries below 2% and funding costs set to rise and with 10-year Bunds and 10-year JGBs yielding less than 0.5%, these investors will have little choice other than to reconsider equity allocations. Second, we see potential for a meaningful reallocation towards equities from insurance companies. Insurers have been huge sellers of equities over the past years on the back of changes in capital regulation and an increased focus on assetliability management. We do not expect a complete reversal of this move but the risk-reward case for equities has improved enormously. Last, but certainly not least, we expect to see further demand from the corporate sector as companies look to benefit from extremely low rates to refinance and buy back their equity. With low yields everywhere shareholders are increasingly demanding that companies return cash to them and this theme seems likely to be enduring. The cult of the bond is not dead yet The end of the twenty year bull market in bonds, when it comes, will likely have very little to do with what investors are doing in equities The much anticipated "great rotation" out of bonds will probably not be as structural as many commentators believe. Certainly regulatory changes are generating some demand for bonds in sectors such as banking and the pension industry, however as outlined above, this is being offset by falling demand in sectors like insurance. Neither do we expect a strong secular drop in demand for bonds based solely on yield levels. Bond markets are, by nature, much more cyclical than equities over the long term. The current cycle is, however, extremely unusual. There is very little inflation risk to worry bond investors, funding rates are low, and in many regions likely to remain low for a long time. When the bond market does turn, it will be a result of rising risk premia in one of the traditional drivers of bonds: interest rate risk, inflation risk or default risk. However with globalization trends slowing, and oil prices at half what they were a year ago, the inflation outlook remains very benign indeed, which means that even when bond yield so start to rise, they probably do not need to rise very far or very fast. Furthermore, the divergent regional economic outlook allows bond investors to rotate their duration risk across different geographies rather than to rotate across asset classes.

18 18 Citi GPS: Global Perspectives & Solutions January 2015 Michael Saunders Head of West European Economic Research Inflation has moved from coming in higher than expected to coming in lower than expected starting in 2012 in advanced economies Will Advanced Economy Low-flation Persist? Across the OECD as a whole, CPI inflation (excluding the relative volatile food and energy items) has now been at or below 2% YoY each month since the start of 2009 the longest period of sustained low inflation since data began 43 years ago. And low inflation is becoming more widespread. For the first time in at least 55 years, not a single advanced economy (AE) had CPI inflation of 4%-plus in To be sure, the number of advanced economies with inflation over 4% has been quite low over the last 10 years, but until 2014 it was never zero. Indeed, as recently as 2011, a quarter of advanced economies had inflation of 4% YoY or higher. Moreover, recent advanced economies inflation outturns have generally been lower than expected. For example, in , inflation outturns across advanced economies generally overshot central bank forecasts from the end of the prior year, with an average overshoot of 0.5% in 2010 and 0.2% in By contrast, inflation generally undershot in 2012, 2013 and 2014 with notable undershoots in 2014 (at least 0.5%) for the euro area, UK and Sweden. Similarly, overall advanced economy inflation overshot the IMF s forecast in but undershot by % in 2013 and In turn, consensus forecasts for advanced economy inflation have been trending down since late 2012, the longest run of consensus downgrades since the late 1990s. Figure 12. Advanced economies average inflation and breadth of low inflation, Figure 13. Advanced economies inflation outturns compared to central bank forecasts at end of prior year, % % Source: Citi Research Overall OECD Inflation Ex Food/Energy YoY (left) Pct of AEs With CPI Inflation of 4%+ (right) Percentage Points Average Including US (2011 Onwards) Average Excluding US Note: We show the average for inflation outturns compared to central bank forecasts made at the end of the prior year for the US, EMU, Japan, UK, Canada, Australia, Sweden and Switzerland. Figures for Australia only from 2008 onwards. Source: Datastream, Central Banks, Citi Research Persistent weakness in AE inflation is caused by a mix of cyclical and structural factors So what is going on? And will it continue? There have been some country-specific or temporary factors at work. For example, the embargo on various food exports to Russia may have contributed to downward pressure on goods prices in Western Europe, while UK and euro area inflation additionally had been depressed by the end of regulatory and tax-driven price hikes. But, in our view, the persistent weakness of advanced economy inflation mainly reflects a mix of cyclical and structural factors, both national and global.

19 January 2015 Citi GPS: Global Perspectives & Solutions 19 Generally, growth prospects are overstated by central banks while disinflationary effects have been understated from large output goals plus high unemployment There also appears to be more labor market slack than implied by jobless rates reflecting part-time workers looking for full-time work Migrant workers have increased sharply in the euro area and the UK Pay growth in OECD countries as a whole has declined for a given jobless rate Domestically, we suspect that the consensus (and central banks) have probably overstated growth prospects and understated the disinflationary effects from large output goals plus high unemployment. Across the advanced economies as a whole, the level of real GDP per head of the population in 2014 is only about 2% above the 2007 level, the weakest multi-year stretch of the last 30 years. In turn, the IMF judges that there is still a relatively large output gap for the AEs as a whole the sixth consecutive year with a sizeable output gap. The overall OECD jobless rate has fallen by 0.6 percentage points (from 7.9% to 7.3%) over the last year but has not been above 7% for six consecutive years the longest stretch for at least 3 years. With ample labor market slack, overall OECD pay growth has slowed from an average of 3.0% YoY in to an average of just 2.0% YoY since the start of 2010, with unit labor cost growth down from 1.4% YoY in to just 0.7% YoY since the start of Moreover, there are signs in some countries that there may be even more labor market slack than implied by jobless rates alone. In the US, the jobless rate at 5.8% is fairly close to the pre-crisis average ( average was 4.9%, a period for which the IMF judged the output gap on average was close to zero), but wider measures of unemployment and under-employment remain well above pre-crisis norms. For example, the U6 measure 3 is at 11.4% as of October 2014 versus the 8.5% average for , reflecting a high number of people working part time but available and looking for full time work, as well as people who have recently looked for work but not in the latest month. We have calculated a similar U6-type jobless measure for the euro area and find the broader measure was at 23.5% in the second quarter among people aged years, up from 17.4% in the second quarter of 2007 and more than twice the standard jobless rate. As with the US, the gap between this wider jobless measure and the standard jobless rate has widened markedly over the last 10 years reflecting in particular a sharp rise in the number of involuntary part time workers who would like to work full time. In addition, inflows of foreign workers via migration and internal company transfers add an extra aspect to labor supply across a wide range of areas. Since 2005, the number of foreign nationals in work has risen by 30% in the euro area and by 84% in the UK; whereas the number of domestic citizens in work has fallen by 0.6% in the euro area and has risen by just 0.4% in the UK. And in the UK, a series of tax and benefit reforms also have expanded internal labor supply with the participation rate close to record highs and added to downward pressure on real wages. There is tentative evidence that, across the OECD countries as a whole, the relation between unemployment and pay growth appears to have shifted downward since 2008 (i.e. pay growth is lower for a given jobless rate). We stress that this evidence is still only tentative at this stage. This is partly because this relationship is quite imprecise. But, in addition, the case for a structural break in this relation will only become more certain if and when jobless rates return to the pre-crisis norms. Moreover, this apparent shift in part reflects the limitations of the standard jobless rate as a guide to labor market slack at a time of structural change: the evidence for a shift in the link between unemployment and nominal wage growth probably would be much weaker if we use a wider U6-type jobless measure. But, at the very least, there is no evidence that hysteresis-type effects are preventing high unemployment from bearing down on wage growth. 3 U6 counts the unemployed, plus discouraged workers, people who have looked for work recently but not within the last few weeks and people working part time but who would like to work full time.

20 20 Citi GPS: Global Perspectives & Solutions January 2015 Strong global growth may have masked disinflationary conditions in AE In addition, we suspect that central banks and investors probably have understated the spillovers to inflation in individual advanced economy countries from swings in global growth and capacity pressures, transmitted in particular via swings in commodity prices and prices of traded goods and services. For example, in , advanced economies in general had disinflationary conditions of large output gaps, high unemployment and sluggish wage growth. However, global growth (using IMF data at constant prices) was above average, fuelled in particular by emerging markets, with the result that advanced economy inflation generally overshot consensus and central bank expectations. Conversely, in , global growth slowed below trend, and the resultant weakness in commodity prices has reinforced the weakness in advanced economy inflation. Whereas the correlation between the change in overall advanced economy inflation and the change in the overall advanced economy output gap has been fairly stable in recent years, the correlation between the change in advanced economy inflation and emerging market GDP growth (a proxy for the change in the emerging market output gap) has risen sharply to 80-90% over the last five years. Moreover, revisions to consensus inflation forecasts have tended to follow (with a lag) swings in global community prices (in SDR terms 4 ): the fact that the adjustment to consensus inflation forecasts does not appear to be immediate suggests that the consensus sometimes may be slow to recognize the importance of external factors in driving each country s inflation. AE inflation in general should remain subdued through 2018 We expect that advanced economy inflation in general will remain subdued, at about 1.25% YoY in , close to the 2014 pace and reflecting much of the same factors as recently: there is still some spare capacity in the labor market while recent declines in food and energy prices will continue to feed through. Within that, we see even lower inflation in the euro area, slightly higher in the US, but do not expect an advanced economy to have inflation of more than 3% YoY in any year during If emerging market growth continues to disappoint, then renewed weakness in commodity prices may well add further downside to advanced economy inflation compared to our forecast and current levels. What s Wrong with Low-flation? There is widespread consensus among policymakers that both very high inflation and deflation are costly and should be avoided 5. High inflation disrupts economic activity because of the adverse interplay with tax systems, difficulties in disentangling relative price changes from the general inflationary trend, and the inefficiencies as businesses, households and investors focus heavily on trying to avoid being on the wrong side of unexpected and large price hikes. Conversely, deflation magnifies debt burdens, especially given difficulties in setting interest rates significantly below zero. But a long period of very low inflation (i.e. low-flation) can be costly as well. To be sure, it may be marginally easier for businesses and consumers to perceive relative price changes if inflation is 1% rather than 2%. But, with many central banks unwilling to push nominal policy rates significantly below zero and given nominal wage rigidity, very low inflation (and repeatedly lower-than-expected inflation) can make it harder to achieve declines in real interest rates and real wages, even if such declines are warranted by economic developments. In addition, if (as we believe is the case) persistent low advanced economy inflation is a symptom of persistent 4 The SDR is an international reserve asset which is valued based on a basket for four key international currencies. 5 See, for example, Price stability Why is it important for you?, ECB, 2011.

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